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# Consumer theory 2

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### Consumer theory 2

1. 1. Chapter 4Individual and Market Demand
2. 2. CONSUMER CHOICE©2005 Pearson Education, Inc.
3. 3. Consumer Choice Given preferences and budget constraints, how do consumers choose what to buy? Consumers choose a combination of goods that will maximize their satisfaction, given the limited budget available to them©2005 Pearson Education, Inc. Chapter 3 3
4. 4. The Budget Line Clothing A (I/PC) = 40 ∆C 1 PF Slope = = - =- B ∆F 2 PC 30 10 D 20 20 E 10 G Food 0 20 40 60 80 = (I/PF)©2005 Pearson Education, Inc. Chapter 3 4
5. 5. Indifference Map Clothing Market basket A is preferred to B. Market basket B is D preferred to D. B A U3 U2 U1 Food©2005 Pearson Education, Inc. 5
6. 6. HOW DO CONSUMERS CONSUME?©2005 Pearson Education, Inc. 6
7. 7. Consumer Choice Clothing (units per week) 40 A 30 D 20 C U3 U1 U2 B 0 20 40 80 Food (units per week)©2005 Pearson Education, Inc. Chapter 3 7
8. 8. Consumer Choice Graphically, we can see different indifference curves of a consumer choosing between clothing and food Remember that U3 > U2 > U1 for our indifference curves Consumer wants to choose highest utility within their budget©2005 Pearson Education, Inc. Chapter 3 8
9. 9. Consumer Choice Clothing (units per week) •A, B, C on budget line 40 •D highest utility but not affordable A 30 D 20 C U3 U1 U2 B 0 20 40 80 Food (units per week)©2005 Pearson Education, Inc. Chapter 3 9
10. 10. Consumer Choice  The maximizing market basket must satisfy two conditions: 1. It must be located on the budget line  They spend all their income – more is better 1. It must give the consumer the most preferred combination of goods and services©2005 Pearson Education, Inc. Chapter 3 10
11. 11. Consumer Choice Clothing (units per week) •A, B, C on budget line 40 •D highest utility but not affordable A •C highest affordable utility 30 D •Consumer chooses C 20 C U3 U1 U2 B 0 20 40 80 Food (units per week)©2005 Pearson Education, Inc. Chapter 3 11
12. 12. Consumer Choice Consumer will choose highest indifference curve on budget line In previous graph, point C is where the indifference curve is just tangent to the budget line Slope of the budget line equals the slope of the indifference curve at this point©2005 Pearson Education, Inc. Chapter 3 12
13. 13. Consumer Choice Recall, the slope of an indifference curve is: ∆C MRS = − ∆F Further, the slope of the budget line is: PF Slope = − PC©2005 Pearson Education, Inc. Chapter 3 13
14. 14. Consumer Choice Therefore, it can be said at consumer’s optimal consumption point, PF MRS = PC©2005 Pearson Education, Inc. Chapter 3 14
15. 15. Marginal Utility and Consumer Choice When consumers maximize satisfaction: MRS = PF /PC Since the MRS is also equal to the ratio of the marginal utility of consuming F and C MU F /MU C = PF /PC©2005 Pearson Education, Inc. Chapter 3 15
16. 16. Marginal Utility and Consumer Choice Rearranging, gives the equation for utility maximization: MU F / PF = MU C / PC©2005 Pearson Education, Inc. Chapter 3 16
17. 17. Consumer Choice It can be said that satisfaction is maximized when marginal rate of substitution (of F and C) is equal to the ratio of the prices (of F and C) Note this is ONLY true at the optimal consumption point©2005 Pearson Education, Inc. Chapter 3 17
18. 18. Marginal Utility and Consumer Choice Total utility is maximized when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good. This is referred to as the equal marginal principle.©2005 Pearson Education, Inc. Chapter 3 18
19. 19. Consumer Choice If MRS ≠ PF/PC then individuals can reallocate basket to increase utility If MRS > PF/PC Will increase food and decrease clothing until MRS = PF/PC If MRS < PF/PC Will increase clothing and decrease food until MRS = PF/PC©2005 Pearson Education, Inc. Chapter 3 19
20. 20. Consumer Choice Clothing (units per week) Point B does not maximize satisfaction 40 because the MRS = -10/10 = 1 is greater than the B 30 price ratio = 1/2 -10C 20 +10F U1 0 20 40 80 Food (units per week)©2005 Pearson Education, Inc. Chapter 3 20
21. 21. Consumer Choice: An Application Revisited Consider two groups of consumers, each wishing to spend \$10,000 on the styling and performance of a car Each group has different preferences©2005 Pearson Education, Inc. Chapter 3 21
22. 22. Consumer Choice: An Application Revisited By finding the point of tangency between a group’s indifference curve and the budget constraint, auto companies can see how much consumers value each attribute©2005 Pearson Education, Inc. Chapter 3 22
23. 23. Consumer Choice: An Application Revisited Styling \$10,000 These consumers want performance worth \$7000 and styling worth \$3000 \$3,000 \$7,000 \$10,000 Performance©2005 Pearson Education, Inc. Chapter 3 23
24. 24. Consumer Choice: An Application Revisited Styling These consumers \$10,000 want styling worth \$7000 and performance worth \$7,000 \$3000 \$3,000 \$10,000 Performance©2005 Pearson Education, Inc. Chapter 3 24
25. 25. Consumer Choice: An Application Revisited Once a company knows preferences, it can design a production and marketing plan Company can then make a sensible strategic business decision on how to allocate performance and styling on new cars©2005 Pearson Education, Inc. Chapter 3 25
26. 26. CORNER SOLUTION©2005 Pearson Education, Inc. Chapter 4 26
27. 27. Consumer Choice A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another MRS is not necessarily equal to PA/PB©2005 Pearson Education, Inc. Chapter 3 27
28. 28. A Corner Solution Frozen Yogurt (cups monthly) A A corner solution exists at point B. U1 U2 U3 B Ice Cream (cup/month)©2005 Pearson Education, Inc. Chapter 3 28
29. 29. A Corner Solution  At point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line  If the consumer could give up more frozen yogurt for ice cream, he would do so  However, there is no more frozen yogurt to give up  Opposite is true if corner solution was at point A©2005 Pearson Education, Inc. Chapter 3
30. 30. A Corner Solution When a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio In this instance it can be said that: PIceCream MRS ≥ PFrozen Yogurt©2005 Pearson Education, Inc. Chapter 3 30
31. 31. A Corner Solution If the MRS is, in fact, significantly greater than the price ratio, then a small decrease in the price of frozen yogurt will not alter the consumer’s market basket©2005 Pearson Education, Inc. Chapter 3 31
32. 32. A Corner Solution - Example Suppose Jane Doe’s parents set up a trust fund for her college education The money must be used only for education Although a welcome gift, an unrestricted gift might be better©2005 Pearson Education, Inc. Chapter 3 32
33. 33. A Corner Solution - Example Original budget line, PQ, with a market basket, A, of education and other goods Trust fund shifts out the budget line as long as trust fund, PB, is spent on education Jane increases satisfaction, moving to higher indifference curve, U2©2005 Pearson Education, Inc. Chapter 3 33
34. 34. A Corner Solution - Example Other Consumption (\$) •Jane better off on U2 •B is corner solution P B •MRS ≠ PE/POG U2 A U1 Q Education (\$)©2005 Pearson Education, Inc. Chapter 3 34
35. 35. A Corner Solution - Example Other Consumption (\$) •If gift is unrestricted, Jane C can be at point C on U3 U3 •Better off than P with restricted gift B U2 A U1 Q Education (\$)©2005 Pearson Education, Inc. Chapter 3 35
36. 36. Individual Demand Price Changes  Using the figures developed in the previous chapter, the impact of a change in the price of food can be illustrated using indifference curves  For each price change, we can determine how much of the good the individual would purchase given their budget lines and indifference curves©2005 Pearson Education, Inc. Chapter 4 36
37. 37. DERIVING DEMAND FROM CONSUMER CHOICE©2005 Pearson Education, Inc. Chapter 4 37
38. 38. Effect of a Price Change Clothing Assume: • I = \$20 10 • PC = \$2 • PF = \$2, \$1, \$0.50 6 A Each price leads to U1 D different amounts of 5 B food purchased 4 U3 U2 Food (units per month) 4 12 20©2005 Pearson Education, Inc. Chapter 4 38
39. 39. Effect of a Price Change Clothing The Price- 10 Consumption Curve traces out the utility maximizing market basket for each price 6 A of food U1 D 5 B 4 U3 U2 Food (units per month) 4 12 20©2005 Pearson Education, Inc. Chapter 4 39
40. 40. Effect of a Price Change  By changing prices and showing what Demand Schedule the consumer will purchase, we can P Q create a demand schedule and \$2.00 4 demand curve for the \$1.00 12 individual  From the previous \$0.50 20 example:©2005 Pearson Education, Inc. Chapter 4 40
41. 41. Effect of a Price Change Price of Food E Individual Demand relates \$2.00 the quantity of a good that a consumer will buy to the price of that good. G \$1.00 Demand Curve \$.50 H Food (units 4 12 20 per month)©2005 Pearson Education, Inc. Chapter 4 41
42. 42. Demand Curves – Important Properties The level of utility that can be attained changes as we move along the curve At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the MRS of food for clothing equals the ratio of the prices of food and clothing©2005 Pearson Education, Inc. Chapter 4 42
43. 43. Effect of a Price Change Price of Food E When the price falls, \$2.00 Pf /Pc & MRS also fall • E: Pf /Pc = 2/2 = 1 = MRS • G: Pf /Pc = 1/2 = .5 = MRS G \$1.00 • H:Pf /Pc = .5/2 = .25 = MRS \$.50 H Demand Curve Food (units 4 12 20 per month)©2005 Pearson Education, Inc. Chapter 4 43
44. 44. Substitutes & Complements If the price consumption curve is downward-sloping, the two goods are considered substitutes If the price consumption curve is upward- sloping, the two goods are considered complements They could be both©2005 Pearson Education, Inc. Chapter 4 44
45. 45. CONSUMER CHOICE AND INCOME CHANGES©2005 Pearson Education, Inc. Chapter 4 45
46. 46. Individual Demand Income Changes Using the figures developed in the previous chapter, the impact of a change in the income can be illustrated using indifference curves Changing income, with prices fixed, causes consumers to change their market baskets©2005 Pearson Education, Inc. Chapter 4 46
47. 47. Effects of Income Changes Clothing (units per Assume: Pf = \$1, Pc = \$2 month) I = \$10, \$20, \$30 An increase in income, with the prices fixed, causes consumers to alter their choice of 7 D market basket. U3 5 U2 B 3 A U1 Food (units 4 per month) 10 16©2005 Pearson Education, Inc. Chapter 4 47
48. 48. Individual Demand Income Changes The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level©2005 Pearson Education, Inc. Chapter 4 48
49. 49. Individual Demand Income Changes  An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve  Simultaneously, the increase in income shifts the demand curve to the right©2005 Pearson Education, Inc. Chapter 4 49
50. 50. Effects of Income Changes Clothing (units per The Income Consumption month) Curve traces out the utility maximizing market basket for each income level Income Consumption 7 D Curve U3 5 U2 B 3 A U1 Food (units 4 per month) 10 16©2005 Pearson Education, Inc. Chapter 4 50
51. 51. Effects of Income Changes Price An increase in income, from of \$10 to \$20 to \$30, with the food prices fixed, shifts the consumer’s demand curve to the right as well. E G H \$1.00 D3 D2 D1 Food (units 4 10 16 per month)©2005 Pearson Education, Inc. Chapter 4 51
52. 52. Individual Demand Income Changes When the income-consumption curve has a positive slope: The quantity demanded increases with income The income elasticity of demand is positive The good is a normal good©2005 Pearson Education, Inc. Chapter 4 52
53. 53. Individual Demand Income Changes When the income-consumption curve has a negative slope: The quantity demanded decreases with income The income elasticity of demand is negative The good is an inferior good©2005 Pearson Education, Inc. Chapter 4 53
54. 54. An Inferior Good Steak Both hamburger (units per Income-Consumption and steak behave month) Curve as a normal good, C between A and B... 10 U3 …but hamburger becomes an inferior good when the income B consumption curve 5 bends backward between B and C. U2 A U1 Hamburger 30 (units per month) 5 10 20©2005 Pearson Education, Inc. Chapter 4 54
55. 55. Individual Demand Engel Curves  Engel curves relate the quantity of good consumed to income  If the good is a normal good, the Engel curve is upward sloping  If the good is an inferior good, the Engel curve is downward sloping©2005 Pearson Education, Inc. Chapter 4 55
56. 56. Engel Curves Income 30 (\$ per month) Engel curves slope 20 upward for normal goods. 10 Food (units 4 8 12 16 per month)©2005 Pearson Education, Inc. Chapter 4 56
57. 57. Engel Curves Income 30 (\$ per month) Inferior Engel curves are 20 backward bending for inferior goods. Normal 10 Food (units 4 8 12 16 per month)©2005 Pearson Education, Inc. Chapter 4 57
58. 58. Annual US Household Consumer Expenditures©2005 Pearson Education, Inc. Chapter 4 58
59. 59. INCOME AND SUBSTITUTION EFFECT©2005 Pearson Education, Inc. Chapter 4 59
60. 60. Income and Substitution Effects A change in the price of a good has two effects: Substitution Effect Income Effect©2005 Pearson Education, Inc. Chapter 4 60
61. 61. Income and Substitution Effects Substitution Effect Relative price of a good changes when price changes Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is relatively more expensive©2005 Pearson Education, Inc. Chapter 4 61
62. 62. Income and Substitution Effects Income Effect Consumers experience an increase in real purchasing power when the price of one good falls©2005 Pearson Education, Inc. Chapter 4 62
63. 63. Income and Substitution Effects Substitution Effect The substitution effect is the change in an item’s consumption associated with a change in the price of the item, with the level of utility held constant When the price of an item declines, the substitution effect always leads to an increase in the quantity demanded of the good©2005 Pearson Education, Inc. Chapter 4 63
64. 64. Income and Substitution Effects Income Effect The income effect is the change in an item’s consumption brought about by the increase in purchasing power, with the price of the item held constant When a person’s income increases, the quantity demanded for the product may increase or decrease©2005 Pearson Education, Inc. Chapter 4 64
65. 65. Income and Substitution Effects Income Effect Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect©2005 Pearson Education, Inc. Chapter 4 65
66. 66. Income and Substitution Effects: Normal Good Clothing When the price of food falls,(units per consumption increases by F1F2 month) R as the consumer moves from A to B. The substitution effect, F1E, (from point A to D), changes the C1 A relative prices but keeps real income (satisfaction) constant. The income effect, EF2, (from D to B) keeps relative D B prices constant but C2 increases purchasing power. Substitution U2 Effect U1 Food (units O F1 Total Effect E S F2 T per month)©2005 Pearson Education, Inc. Chapter 4 Income Effect 66
67. 67. Income and Substitution Effects: Inferior Good Clothing(units per Since food is an month) R inferior good, the income effect is negative. However, the substitution effect A is larger than the income effect. B U2 D Substitution Effect U1 Food (units O F1 E S F2 T per month) Total Effect©2005 Pearson Education, Inc. Chapter 4 Income Effect 67
68. 68. Income and Substitution Effects A Special Case: The Giffen Good The income effect may theoretically be large enough to cause the demand curve for a good to slope upward This rarely occurs and is of little practical interest©2005 Pearson Education, Inc. Chapter 4 68
69. 69. Market Demand Market Demand Curves A curve that relates the quantity of a good that all consumers in a market buy to the price of that good The sum of all the individual demand curves in the market©2005 Pearson Education, Inc. Chapter 4 69
70. 70. MARKET DEMAND©2005 Pearson Education, Inc. Chapter 4 70
71. 71. Determining the Market Demand Curve Market Price A B C Demand 1 6 10 16 32 2 4 8 13 25 3 2 6 10 18 4 0 4 7 11 5 0 2 4 6©2005 Pearson Education, Inc. Chapter 4 71
72. 72. Summing to Obtain a Market Demand Curve Price 5 The market demand curve is obtained by summing the consumer’s 4 demand curves 3 Market Demand 2 1 DA DB DC 0 5 10 15 20 25 30 Quantity©2005 Pearson Education, Inc. Chapter 4 72
73. 73. Market Demand From this analysis one can see two important points: The market demand will shift to the right as more consumers enter the market Factors that influence the demands of many consumers will also affect the market demand©2005 Pearson Education, Inc. Chapter 4 73
74. 74. Market Demand Aggregation is important to be able to discuss regarding demand for different groups Households with children Consumers aged 20 – 30, etc.©2005 Pearson Education, Inc. Chapter 4 74
75. 75. The Aggregate Demand for Wheat The demand for US wheat is comprised of two components: Domestic demand Export demand Total demand for wheat can be obtained by aggregating these two demands©2005 Pearson Education, Inc. Chapter 4 75
76. 76. The Aggregate Demand for Wheat The domestic demand for wheat is given by the equation: QDD = 1465 - 88P The export demand for wheat is given by the equation: QDE = 1344 - 138P©2005 Pearson Education, Inc. Chapter 4 76
77. 77. The Aggregate Demand for Wheat Domestic demand is relatively price inelastic (Ed = -0.2) Export demand is more price elastic (Ed = -0.4) Poorer countries that import US wheat turn to other grains and food if wheat prices increase©2005 Pearson Education, Inc. Chapter 4 77
78. 78. The Aggregate Demand for Wheat Price Total world demand is 18 the horizontal sum of the domestic demand AB and A export demand CD. 16 Above C, export demand is zero, so domestic demand = total demand = AE segment 10 C E Total Demand Export Demand Domestic Demand D B F 0 Wheat©2005 Pearson Education, Inc. Chapter 4 78
79. 79. CONSUMER SURPLUS©2005 Pearson Education, Inc. Chapter 4 79
80. 80. Consumer Surplus Consumers buy goods because it makes them better off Consumer Surplus measures how much better off they are©2005 Pearson Education, Inc. Chapter 4 80
81. 81. Consumer Surplus Consumer Surplus The difference between the maximum amount a consumer is willing to pay for a good and the amount actually paid Can calculate consumer surplus from the demand curve©2005 Pearson Education, Inc. Chapter 4 81
82. 82. Consumer Surplus - Example Student wants to buy concert tickets Demand curve tells us willingness to pay for each concert ticket 1st ticket worth \$20 but price is \$14 so student generates \$6 worth of surplus Can measure this for each ticket Total surplus is addition of surplus for each ticket purchased©2005 Pearson Education, Inc. Chapter 4 82
83. 83. Consumer Surplus - Example Price The consumer surplus (\$ per 20 of purchasing 6 concert ticket) tickets is the sum of the 19 surplus derived from 18 each one individually. 17 16 Consumer Surplus 15 6 + 5 + 4 + 3 + 2 + 1 = 14 21 Market Price 13 Will not buy more than 7 because surplus is negative 0 1 2 3 4 5 6 Rock Concert Tickets©2005 Pearson Education, Inc. Chapter 4 83
84. 84. Consumer Surplus The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller Consumer surplus is the area under the demand curve and above the price©2005 Pearson Education, Inc. Chapter 4 84
85. 85. Consumer Surplus Price Consumer Surplus (\$ per 20 ticket) for the Market Demand 19 18 CS = ½ (\$20 - \$14)*(1600) = \$19,500 17 16 Consumer Surplus 15 14 Market Price 13 Demand Curve Actual Expenditure 0 1 2 3 4 5 6 Rock Concert Tickets©2005 Pearson Education, Inc. Chapter 4 85
86. 86. Applying Consumer Surplus  Combining consumer surplus with the aggregate profits that producers obtain, we can evaluate: 1. Costs and benefits of different market structures 2. Public policies that alter the behavior of consumers and firms©2005 Pearson Education, Inc. Chapter 4 86
87. 87. Applying Consumer Surplus – An Example The Value of Clean Air Air is free in the sense that we don’t pay to breathe it The Clean Air Act was amended in 1970 Question: Were the benefits of cleaning up the air worth the costs?©2005 Pearson Education, Inc. Chapter 4 87
88. 88. The Value of Clean Air Empirical data determined estimates for the demand for clean air No market exists for clean air, but can see people are willing to pay for it Ex: People pay more to buy houses where the air is clean©2005 Pearson Education, Inc. Chapter 4 88
89. 89. The Value of Cleaner Air Using these empirical estimates, we can measure people’s consumer surplus for pollution reduction from the demand curve©2005 Pearson Education, Inc. Chapter 4 89
90. 90. Valuing Cleaner Air Value The shaded area represents the 2000 consumer surplus generated when air pollution is reduced by 5 parts per 100 million of nitrous oxide at a cost of \$1000 per part reduced. A 1000 NOX (pphm) 0 5 10 Pollution Reduction©2005 Pearson Education, Inc. Chapter 4 90
91. 91. Value of Cleaner Air A full cost-benefit analysis would include total benefit of cleanup Total benefits would be compared to total costs to determine if the clean up was worthwhile©2005 Pearson Education, Inc. Chapter 4 91